Shipping Terms Done Right
Using the wrong shipping terms could cost your business millions. This post gives you what you need to know to avoid that.
If you purchase products from China (or most anywhere else overseas), do NOT use FOB as a shipping term.
Use FCA or CIF (my usual favorite) or even EXW. But eliminate FOB from your vocabulary starting NOW. After you do that, get a copy of Incoterms, and learn what the above shipping terms mean and use them exactly as specified. Do not use the UCC. Use Incoterms only. Do not edit the terms. Just do it. If you do this, you do not need to read this post.
The Risks of Using FOB
Before you decide this is just a trivial issue, think again. Before you go on, please go to Wikipedia and read about the Tianjin Port Explosion of 2015. Eight thousand new cars were destroyed along with “large quantities of intermodal container stacks”. Total damages were estimated at $9 billion. Now think about who bore the loss of all this destruction. Was it the seller or the buyer? Will any insurance company pay for the loss? Or did they escape the obligation to pay because in fact no insurance covered the items sitting in the port waiting for delivery? If you thought the issue was trivial before, this sort of thing ought to make you think again.
A Typical International Transaction Using FOB
Think about it. You are a U.S. or EU company that purchases product from China per a contract manufacturing arrangement. The completed product is packed into a container at your Chinese factory, transported from that factory to the port by truck. The container sits in a processing yard at the port for a week and then is finally loaded onto the ship.
There is a lot that can go wrong in this process. For today, we will consider the issue of risk of loss. That is, who gets paid if the container is lost? What happens if the truck carrying the container to the port is involved in an accident and the entire shipment is destroyed? What happens if the container is stolen from the port? What happens if there is an explosion at the port and the container is destroyed? What happens if the ship sinks in a storm in the Gulf of Alaska? What happens if the container is offloaded and the same misadventures happen before the container is delivered to you, the buyer, at your facility in the United States?
Risk of Loss vs. Title to Goods
Risk of loss is determined by the shipping terms used for the transaction. Title to the goods is a separate legal concept that determines ownership. For international shipments, shipping terms have been carefully developed over many years and are embodied in Incoterms as written by the International Chamber of Commerce. Incoterms cover virtually all of the important issues relating to the international shipment of goods, including both risk of loss and title. Selection of a single term resolves virtually all of the important issues. For this reason, every buyer must decide what term will be used and then operate in compliance with the selected term.
Why FOB is Problematic for Buyers
When I discuss this with clients, they’re usually indifferent. I’ve had clients suggest that my insistence on precision is just an international lawyer’s pedantic obsession, with no application to the real world of business. The opposite is true. Risk of loss is a fundamental issue for all international trade business. Failure to do it right is not a technical issue. Consider this example:
A furniture manufacturer in China shipped a container of tables and chairs to a importer in the US under FOB terms. During transit from the factory to the port, the truck was involved in an accident and the entire shipment was destroyed. Under FOB, risk had not yet transferred to the buyer. But neither the Chinese manufacturer nor the American importer had insured the goods for this stage of transport. Both parties suffered significant financial losses as their insurance claims were denied. This illustrates the very real risks of the uninsured period under FOB terms.
So where does risk of loss transfer? This issue is decided by the choice of shipping terms. In my experience, most U.S. and EU buyers make the mistake of choosing Free On Board (FOB) as their shipping term. They make this choice as a pricing term. That is, they choose FOB to ensure the price of the product does not include the price of insurance and freight to ship the product from China to the U.S.
When they choose FOB, these buyers do not account for their risk of loss. Under FOB, risk of loss passes only after the product has been loaded onto the vessel (crosses the rail). Since risk of loss transfers when the product crosses the rail, the buyer purchases insurance that covers the product at that point. Now ask yourself: who has the risk of loss from the time when the product leaves the factory until the time the product is loaded onto the ship? The answer of course is that the factory has the risk of loss.
But I have NEVER encountered a case in which a Chinese company has purchased insurance for the brief period between when the product leaves its factory until it is loaded on the vessel. The factory just assumes the buyer has purchased insurance AS IF the risk transfers when the carrier takes delivery. But this is not true.
In my experience, during the period between delivery to the carrier and loading on the vessel, the risk of loss for the product is uninsured. If the buyer is aware that the product is uninsured, then that is a risk the buyer willingly assumes. However, I’ve only rarely worked with a buyer that understood they were taking this considerable risk with product they may already have paid for. That is, many Chinese factories will demand full payment at the time the product is put into the control of the carrier. They do not want to wait until the product is loaded on the vessel because they can never be sure when this will happen.
Here are a few more examples of how using FOB can create problems:
- The product could be damaged in transit before being loaded on the vessel. Neither the seller nor buyer may have insurance to cover this.
- If there is a delay in loading the vessel, the buyer bears the risk and cost of storing the product.
- The buyer has no control over when the product is loaded and cannot confirm exactly when risk transfers.
The Solution: Use FCA Instead
The solution to this problem is simple. Use the right shipping term. As the drafters of Incoterms clearly state, for modern shipping by sea, the FOB term should never be used. The proper term is Free Carrier (FCA). Under FCA terms, risk of loss passes when the shipment is put into the custody of the carrier. It does not matter where the carrier takes delivery. It may be at the factory, or it may be at the port. Since the buyer can be certain where risk of loss passes, the buyer can be certain that it has obtained the appropriate insurance. The issue of insurance is not left to the seller. The responsibility and benefit of insurance rests on the buyer which is where it belongs.
You should also consider doing the following
- Use FCA terms so risk transfers when goods are delivered to the carrier.
- Consult Incoterms 2020 to understand all obligations for chosen shipping term. See https://iccwbo.org.
- Discuss insurance options with your insurance provider early in the purchasing process.
- Negotiate who will insure goods in transit before vessel loading.
- Require written confirmation from suppliers that goods are insured as agreed.
The Perils of Custom Terms
A related and even more difficult problem arises when buyers define their own terms that simply make no sense. In this area, the problems arise when buyers confuse risk of loss, transfer of title and acceptance of product. In a recent case, I reviewed a contract in which a buyer provided the shipping term would be FOB, but risk of loss would transfer only after the product was delivered, inspected and accepted. FOB means risk of loss transfers when the shipment is loaded on the vessel. It does not mean anything else.
For this reason, the language provided by the buyer simply did not make sense. In fact, there is NO shipping term that provides for transfer of risk of loss under these terms. In this case, the buyer has confused risk of loss with acceptance of the goods, two entirely unrelated concepts. But by providing internally incoherent contract language, the buyer did nothing but harm themselves. The only possible result is that insurance for the product would be purchased on entirely random terms. If the shipment is lost, will the insurance company pay? If it pays, who will it pay: the factory or the buyer? Who knows.
The purpose of a contract is to make business terms more predictable. This failure to use standard terms in the standard way makes the situation less predictable, all to the detriment of the buyer. Why do that? It makes no sense to me. So just stop it and do the right thing. It’s for your own good.
Using undefined or ambiguous shipping terms for international trade can expose both buyers and sellers to serious financial and legal risks. A period without clear insurance coverage leaves businesses vulnerable to losses through no fault of their own. Standard Incoterms like FCA and CIF define responsibilities clearly and avoid these potential pitfalls.
For companies engaged in global trade, taking the time to choose the right shipping term according to Incoterm definitions is a fundamental part of mitigating risks. Choosing terms without understanding their definitions or responsibilities increases risk. Following the Incoterms precisely gives businesses the predictability they need to manage risk and ensure a successful trading relationship. Taking the small step of learning Incoterms properly can save companies large headaches down the road.